1. The Foreign Exchange Market
Chapter 20
The Foreign Exchange Market

2. Foreign Exchange I
Exchange rate—price of one currency in terms of another
Foreign exchange market—the financial market where exchange rates are determined
Spot transaction—immediate (two-day) exchange of bank deposits
Spot exchange rate
Forward transaction—the exchange of bank deposits at some specified future date
Forward exchange rate
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3. Foreign Exchange II
Appreciation—a currency rises in value relative to another currency
Depreciation—a currency falls in value relative to another currency
When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa
Over-the-counter market mainly banks
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5. Exchange Rates in the Long Run
Law of one price
Theory of Purchasing Power Parity
Assumes all goods are identical in both countries
Trade barriers and transportation costs are low
Many goods and services are not traded across borders
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6. Factors that Affect Exchange Rates in the Long Run
Relative price levels
Trade barriers
Preferences for domestic versus foreign goods
Productivity
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9. Exchange Rates in the Short Run
An exchange rate is the price of domestic assets in terms of foreign assets
Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other
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10. Comparing Expected Returns I
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11. Comparing Expected Returns II
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12. Comparing Expected Returns III
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13. Interest Parity Condition
Capital mobility with similar risk and liquidity  the assets are perfect substitutes
The domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency
Expected returns are the same on both domestic and foreign assets
An equilibrium condition
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14. Demand and Supply for Domestic Assets
Relative expected return
At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher
Supply
The amount of bank deposits, bonds, and equities in the U.S.
Vertical supply curve
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23. Exchange Rate Overshooting
Monetary Neutrality
In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level
The exchange rate falls by more in the short run than in the long run
Helps to explain why exchange rates exhibit so much volatility
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25. The Dollar and Interest Rates
While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced
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